The 17-country euro zone, and the wider European Union, cannot suffer much more austerity before the streets explode in mass rage, as they have in Athens, Rome, Barcelona, Madrid and Lisbon. (TONY GENTILE/REUTERS)

The 17-country euro zone, and the wider European Union, cannot suffer much more austerity before the streets explode in mass rage, as they have in Athens, Rome, Barcelona, Madrid and Lisbon.(TONY GENTILE/REUTERS)

If I were the owner of sovereign Greek, Spanish, Italian, Irish and Portuguese bonds, maybe even French bonds, I would be nervous. My twitchy feeling would not make a lot of sense to bond investors like hedge fund manager Dan Loeb, whose 2012 bets of rising bond values made fortunes.

Indeed, going long on allegedly dud bonds issued by allegedly bankrupt or near-bankrupt countries turned out to be one of the savviest moves of the entire financial crisis as Mario Draghi, president of the European Central Bank, made good on his promise to do “whatever it takes” to spare the euro from historical footnote status.

So what’s wrong with these soaring sovereign angels? Austerity. National budget deficits are not disappearing; some countries, like Spain, are blowing their deficit-reduction targets. The blown targets will naturally trigger more demands for austerity in a region that is in recession and suffering record unemployment.

But the 17-country euro zone, and the wider European Union, cannot suffer much more austerity before the streets explode in mass rage, as they have in Athens, Rome, Barcelona, Madrid and Lisbon. At times, Athens turned to a war zone.

Pretend you are a government leader and your budget deficits are going the wrong way. You can listen to Mr. Draghi and German Chancellor Angela Merkel and inflict more cutbacks on your people. Or you can whack the bondholders.

The former would constitute another tax on society that cannot take more pain; the later would hurt a much narrower group – rich investors, many of whom are foreigners and do not vote in the countries whose bonds they own.

“Seems to me we are relentlessly approaching the point where further taxing a decimated population or cutting what remains of public services becomes a whole lot less attractive than taxing the bond holders,” Marshall Auerback, a director at New York’s Institute for New Economic Thinking, said in a recent note.

He’s probably right, but punishing the few to avoid punishment of the many would be an ugly process, as it was when private holders of Greek debt were railroaded into taking “haircuts” on their investments.

A year ago, the euro zone finance ministers, with the International Monetary Fund and the ECB at their side, agreed to a second Greek bailout on the condition that the private bond holders accept losses of 53.5 per cent of the face value of their bonds. While the effort trimmed Greece’s debt by about €100-billion ($130-billion), it utterly spooked bond investors elsewhere in Europe. They convinced themselves that if Greek bond holders could be hustled into the barbershop, why not Spanish or Italian bond holders? Yields duly rose – Spanish yields went above the potentially fatal 7-per-cent level – and suddenly there was talk of the bailouts of Spain and Italy, two countries whose financial collapse could destroy the euro zone.

The euro zone finance ministers went into damage control. Talk of Greek-style haircuts elsewhere in the euro zone vanished and, in September, the ECB hauled out the heavy artillery. It promised unlimited purchases of sovereign bonds for countries that were on the verge of losing access to the debt markets. The purchases would be done in conjunction with the European Stability Mechanism, the new, €500-billion permanent rescue fund, and would come with austerity and reform conditions.

The ECB program has yet to be triggered, though its mere existence has sent yields plummeting in the struggling countries. At an Italian bond auction on Thursday, the yield premium demanded by investors fell half a percentage point, and the spread between benchmark one-year Italian bonds and their German equivalent is at its lowest level since July, 2011.

Bond yields are still falling, as if the euro crisis has been magically cured. The euro is soaring against the dollar, and an upbeat Mr. Draghi this week talked about the coming “normalization” of financial markets, even if he predicted only a weak economic recovery in the second half of this year.

But guess what? The recession isn’t over and the euro is on a tear, reaching almost $1.33 (U.S.) on Friday. A high euro will make European exports more expensive, damaging the touted economic recovery. Euro zone unemployment is at a record high and climbing. Youth unemployment ranges from 30 per cent to more than 50 per cent on the euro zone’s Mediterranean frontier. Budget deficits will remain intact as a strong recovery proves elusive; a triple dip recession is not out of the question.

All of this means that austerity will not go away, in spite of the lower sovereign borrowing costs. Remember that the ECB’s bond-buying guarantee is conditional on austerity. The problem is that the spending cutbacks and tax hikes are making already weak economies even weaker.

At some point, politicians could very well decide that debt elimination is the way to go because society at large has suffered enough. If that happens, prepare for an almighty war, because private bond holders will fiercely resist haircuts unless the ECB and other official holders of sovereign debt also take them (Mr. Draghi has said the ECB is not prepared to do this).

Europe’s sovereign bond rally has been a welcome and glorious thing. But it is too good to last and could well end in tears if politicians decide that forcing bond writedowns loses fewer votes than savage austerity.

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